QFC Financial Engineering & Structured Products 2 — Questions and Answers
Question 1: What is 'prepayment risk' in the context of mortgage-backed securities (MBS)?
- The risk that borrowers default on their mortgage obligations
- The risk that interest rates rise, reducing the MBS market price
- The risk that borrowers repay mortgages faster than expected, forcing reinvestment at lower rates (Correct answer)
- The risk that the servicer fails to remit payments to MBS investors
Correct answer: The risk that borrowers repay mortgages faster than expected, forcing reinvestment at lower rates
Prepayment risk arises when homeowners refinance or sell their homes early, returning principal to MBS investors sooner than expected — most harmful when rates have fallen and reinvestment rates are lower.
Question 2: What is a Collateralized Mortgage Obligation (CMO) and why was it created?
- A government guarantee extended to all classes of mortgage-backed securities
- A structured MBS that redistributes prepayment risk across multiple maturity tranches (Correct answer)
- An insurance contract that protects investors against homeowner default losses
- A floating-rate instrument backed exclusively by adjustable-rate mortgages
Correct answer: A structured MBS that redistributes prepayment risk across multiple maturity tranches
A CMO divides mortgage pool cash flows into tranches with different prepayment characteristics, allowing investors to select exposures that better match their risk tolerance and maturity preferences.
Question 3: What distinguishes 'agency MBS' from 'non-agency MBS'?
- Agency MBS are backed by commercial mortgages; non-agency MBS by residential mortgages
- Agency MBS carry an explicit or implicit government guarantee; non-agency MBS do not (Correct answer)
- Agency MBS use active portfolio management; non-agency MBS are passively managed
- Agency MBS are restricted to institutional investors; non-agency MBS are retail products
Correct answer: Agency MBS carry an explicit or implicit government guarantee; non-agency MBS do not
Agency MBS are issued or guaranteed by GSEs (Fannie Mae, Freddie Mac) or Ginnie Mae, providing protection against credit losses, while non-agency MBS rely solely on the underlying loans' creditworthiness.
Question 4: In MBS analysis, what does the Conditional Prepayment Rate (CPR) measure?
- The probability that an individual borrower will default in a given month
- The annualized fraction of the remaining mortgage pool that is prepaid in a given period (Correct answer)
- The ratio of cumulative credit losses to the original pool balance
- The price sensitivity of an MBS to a parallel shift in interest rates
Correct answer: The annualized fraction of the remaining mortgage pool that is prepaid in a given period
CPR expresses on an annualized basis the percentage of the outstanding mortgage pool that is prepaid in a given period, serving as the key metric for modeling MBS cash flows and duration.
Question 5: What causes 'negative convexity' in mortgage-backed securities?
- MBS prices decline faster than duration-adjusted predictions when rates rise sharply
- MBS price appreciation slows as rates fall because accelerating prepayments shorten duration (Correct answer)
- The yield spread on MBS widens when interest rate volatility increases
- MBS lose market value when the Treasury yield curve inverts
Correct answer: MBS price appreciation slows as rates fall because accelerating prepayments shorten duration
MBS exhibit negative convexity because when rates fall, prepayments accelerate and duration shortens, capping price appreciation relative to a comparable straight bond and causing a concave price-yield relationship.
Question 6: What is an Interest-Only (IO) strip created from mortgage cash flows?
- A tranche that receives only scheduled principal repayments from the mortgage pool
- A tranche that receives only the interest portion of the underlying mortgage payments (Correct answer)
- A zero-coupon bond formed by stripping the coupon from a Treasury bond
- A floating-rate CMO tranche whose coupon resets monthly based on short-term rates
Correct answer: A tranche that receives only the interest portion of the underlying mortgage payments
An IO strip receives only interest payments from the underlying mortgage pool; its value falls sharply as prepayments accelerate because there is less outstanding principal generating interest income.
Question 7: What is 'extension risk' in mortgage-backed securities?
- The risk that MBS maturity extends due to collateral substitution by the servicer
- The risk that rising interest rates slow prepayments, extending the MBS's effective duration (Correct answer)
- The risk that the originator adds lower-quality mortgages to the pool after issuance
- The risk that credit losses extend beyond junior tranches into senior MBS classes
Correct answer: The risk that rising interest rates slow prepayments, extending the MBS's effective duration
Extension risk is the counterpart to prepayment risk: when rates rise, homeowners are less likely to refinance, slowing prepayments and causing the MBS to extend in average life at an inopportune time for investors.
QFC Financial Engineering & Structured Products 2
What is 'prepayment risk' in the context of mortgage-backed securities (MBS)?